Introduction

Suppose you had a coupon for a free ice cream cone from a local ice cream parlor. While walking by the store on a particularly hot day, you decide to redeem your coupon. Leaving the store, you stroll down the street and accidently drop the cone on the ground, rendering the ice cream inedible. You are disappointed at first, but you achieve some comfort by reminding yourself that it was free to begin with. You reason that if you didn’t have to pay for it, it was no real loss. Alternatively, suppose you had been wanting to buy a new video game system. You had contemplated saving for the system, but knew you really needed to save your money for a new pair of eyeglasses. Your prescription had changed substantially and it was beginning to be difficult to do everyday things. One afternoon you check your mail and find that your grandmother has written you a check. It is just enough to purchase either the game system or the new glasses. After thinking about it for a minute or two you decide to purchase the video game system. What kind of a gift would glasses make, anyway?

 Consumers must deal with new income from varied sources and new expenses on a variety of items on a regular basis. Additionally, people face changes in the state of the world (often referred to as shocks) that can render prior investments useless or make them even more valuable. The sheer volume of decisions one must make can lead people to use simple rules of thumb to make decisions rather than to optimize in the way that economic theory suggests. In particular, people can use a system called mental accounting to make decisions as well as to rationalize previous decisions. Mental accounting is a procedure of keeping accounts of income and expenses, similar to that used by corporations, except in this case, each person is his or her own bookkeeper and the books are kept in the ledgers of one’s mind. In the previous chapter, we detailed how people can be motivated by transaction utility — the desire to get a good deal on an item. In a sense, when a sunk cost is incurred, it is entered into the mental ledger as an expense in a particular account. To balance the books, the person then seeks a gain of equal or greater value that allows him to close the mental account. Thus, for example, you might open a mental account when you enter an all-you-can-eat restaurant and pay the admission fee. This account could only be closed by consuming enough food for you to feel you have received a value that exceeds the cost of entry. In this case, you would choose to consume more when the price is higher. Decision making based on mental accounting can lead directly to the transaction utility–based behavior described in the previous chapter, though many other anomalous types of behavior are implicated.

This chapter discusses the full theory of mental accounting and describes several types of behavior that apparently result from this decision heuristic. In particular, we discuss how income source can determine the types of spending, how individual consumers can rationalize bad investments, and how consumers can group events in their mind to obtain a balanced account. Mental accounting is a procedural rational model of consumer choice in that it tells us what is motivating the consumer to make these choices. Although mental accounting can lead to many and varied anomalous decisions, the model itself is surprisingly similar to the accounting methods used by large firms for exactly the same purposes.